chapter 11

Chapter 11: Output and Expenditures in the Short Run The aggregate expenditure model (John Maynard Keynes) Aggregate expenditure model-a macroeconomic model that focuses on the relationship between total spending and the real GDP, assuming that the price level is constant Key idea is that in any particular year, the level of GDP is determined mainly by the level of aggregate expenditure Aggregate expenditure Four categories of aggregate expenditure that together equal GDP: Consumption (C): this is spending by households on goods and services Planned investment (I): this is planned spending by firms on capital goods, and by households on new homes Government purchases (G): this is spending by local, state, and federal governments on goods and services Net exports (NX): this is spending by foreign firms and households on goods and services produced in the US minus spending by US firms and households on goods and services produced in other countries Aggregate expenditure=consumption+planned investment+government purchases+net exports AE=C+I+G+NX The difference between planned investment and actual investment Inventories-goods that have been produced but not yet sold Actual investment will equal planned investment only when there is no unplanned change in inventories Macroeconomic equilibrium Aggregate expenditure=GDP Adjustments to macroeconomic equilibrium When aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase When aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease Determining the level of aggregate expenditure in the economy Consumption Five most important variables that determine the level of consumption: Current disposable income The income remaining to households after they have paid the personal income tax and received government transfer payments Household wealth The value of a households assets minus the value of liabilities Expected future income Current income explains current consumption well but only when current income is not unusually high or unusually low compared with expected future income The price level Measures the average prices of goods and services in the economy Decrease in price level=decrease in real value of household wealth If price level falls, consumption increases The interest rate Nominal interest rate: the state interest rate on a loan or financial investment Real interest rate: nominal interest rate-inflation rate The consumption function Consumption function-the relationship between consumption spending and disposable income Consumption is a function of disposable income Marginal propensity to consume (MPC)-the slope of the consumption function: the amount by which consumption spending changes when disposable income changes MPC=change in consumption/change in disposable income=deltaC/deltaYD Change in consumption=change in disposable income x MPC The relationship between consumption and national income Disposable income=national income-net taxes National income=GDP=disposable income+net taxes Income, consumption, and saving National income=consumption+savings+taxes Y=C+S+T Change in national income=change in consumption+change in savings+change in taxes deltaY=deltaC+deltaS+deltaT deltaT always=0 ( deltaY=deltaC+deltaS Marginal propensity to save (MPS)-the change in savings divided by the change in disposable income deltaY/deltaY=deltaC/deltaY+deltaS/deltaY 1=MPC+MPS Planned investment Four most important variables that determine the level of investment: Expectations of future profitability The optimism of pessimism of firms is an important determinant of investment spending The interest rate A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending Taxes Corporate income tax Investment tax incentives (increase spending) Cash flow Cash flow-the difference between the cash revenues received by a firm and the cash spending by the firm The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment Government purchases All spending by the federal, local and state governments for goods and services Do not include transfer payments Net exports Value of spending by foreign firms and households on goods and services produced in the US and subtracting the value of spending by US firms and households on goods and services produced in other countries Three most important variables that determine the level of net exports: The price level in the US relative to the price level in other countries The growth rate of the GDP in the US relative to the growth rates of GDP in other countries The exchange rate between the dollar and other countries Graphing the macroeconomic equilibrium 45 degree line diagram All points of macroeconomic equilibrium must lie along the 45 degree line USE PAGE 365 Showing a recession on the 45 degree line diagram PAGE 367 The multiplier effect Autonomous expenditure-an expenditure that does not depend on the level of GDP Multiplier-the increase in equilibrium real GDP divided by the increase in autonomous expenditure Multiplier effect-the process by which an increase in autonomous expenditure leads to a larger increase in real GDP To calculate value of multiplier: deltaY/deltaI=change in real GDP/change in investment spending A formula for the multiplier 1/1-MPC Multiplier=change in equilibrium real GDP/change in autonomous expenditure=1/1-MPC Summarizing the multiplier effect The multiplier effect occurs both when autonomous expenditure increases and when it decreases The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be The larger the MPC, the larger the value of the multiplier The formula for the multiplier (1/1-MPC) is over simplified because it ignores some real world complications The aggregate demand curve When considering the factors that determine consumption and net exports: A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect If the price level in the US rises relative to the price levels in other countries, US exports will become relatively more expensive, and foreign imports will become relatively less expensive, causing net exports to fall; falling price level in US has reverse effect When prices rise, firms and households need more money to finance buying and selling. If the central bank doesn?t increase the money supply, the result will be an increase in the interest rate; a falling price level has the reverse effect (interest rates will fall and investment spending will rise) Aggregate demand curve-a curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure